Should We Cash Out the 401k to Pay Off the Mortgage? – Lorriell

My husband and I are Mid-30’s and have been married and investing heavily for 16 years. We are watching our investments plunge. We owe $126K of $194K mortgage. No other debt. We are locked in at 4.75% refi. but wondering if cashing in one of 401K would be better. Wondering about the tax advantages/disadvantages. We are no longer contributing to this particular 401K.

We would put the monthly savings into newer 401K.

Consindering the economy only getting worse, should we cash in one of our 401K to pay off our house?

Lorriell”

The Answer

Dear Lorriell,

I sent your question to the brightest Certified Financial Planner I know, Paul Bennett at c5 Wealth Management. Here is what Paul had to say:

Hi Lorriell,

Although tempting, cashing out your 401k to pay off a mortgage is definitely a finance “no-no”. The reasons are:

You will immediately trigger income taxes on the full 401k cash out.

Since you are younger than 59 1/2 you will trigger a 10% additional tax penalty.

You will no longer have this asset growing tax deferred for retirement; potentially hindering your retirement plans.

Your mortgage – 4.75% is a wonderful rate; and even better than that, after tax, assuming you are in a 25% tax bracket, the interest rate is really just a hair above 3.50%!

Long term (not today, I know the markets are terrible now) you should outperform your effective cost of borrowing which is 3.50% by allocating your assets in a diversified portfolio of mutual funds and/or exchange traded funds.

I would rollover your old 401k into a self-directed IRA where you can accomplish #5 above. This gives you much more choice than the funds available to you in your 401k, I’m sure.

The bottom line is your house will grow or decline in value irrespective of whether or not you pay off your mortgage. Give your money the best chance to grow outside the four walls of your home.

Hope this helps.

Cheers,

Paul

I think Paul has some very good observations and points to consider before you do anything rash.

You make a lot of good points, and I know people who were retired in 2008, lost 1/3 of their portfolio, panicked and sold it all and put it into bonds, effectively locking in their losses. What 70-year-olds were doing playing the market, I don’t know. By that age, they should be 70% into government-backed bonds, in my opinion.

However, as bad as things got in 2008 – with the media making it out to be worse than it was, many people still had positive equity in their savings and their homes.

For example, have you really “lost money” if you put $50,000 in a 401(k) account that zoomed up to $150,000 in value and now has “plummeted” to $100,000? From where I stand, that is still 100% more than what you put in. And one of my 401(k) accounts did just that. It still works out to a 10% annual rate of return.

Similarly, if you paid $200,000 for a house and it zoomed up to $500,000 in value in 2008 and then dropped back to $300,000 today, have you really “lost money” on the house?

Granted, the people who bought in 2008 are screwed. But a lot of people still do have positive equity in their savings and homes. The idiot-media always fails to mention that salient point.

Robertplattbell

I wrote a similar entry in my blog and came to the same conclusion as your financial planner above – the cash-out would knock you into the highest tax bracket, causing you to pay over 1/3 to 1/2 in Federal and State taxes, plus another 10% if you are below 59-1/2. They really have us over a barrel on this one!

The temptation is understandable – people struggling with debt and mortgage payments, but at the same time, seeing that they “have” enough money in their IRA/401(k) to pay off the balance. They have the money, but they don’t.

And then you start to think that perhaps using the IRA Tax Code as an investment guide might not be such a swell idea. You borrow on your house because it is “tax deductible” and at the same time you invest in a 401(k) because it is tax-deferred.

The 401(k) invests in mutual funds, which in tern invest in mortgage-backed securities, which in turn loans money to you in the form of a mortgage. In other words, you are lending money to yourself, paying interest, and paying bankers on both ends of the deal all on the premise that you getting tax deductions.

You cannot deduct your way to wealth, just as you cannot eat your way to slimness.

Paying down debt is a good idea, and long-term, you should look to be debt-free before you retire. But paying off the mortgage with the 401(k) isn’t feasible, due to the tax problems. Note that there are some “self-directed” IRA plans out there that claim you can “lend money to yourself” with them and invest in Real Estate, but these look like audit bait to me.

I cranked the numbers on this, and one thing our investment friend fails to take into account is that if you have no mortgage, and pay that monthly payment into a 401(k) or IRA, it really can grow very quickly into quite a nest egg.

I recently sold my vacation home and am paying off my mortgage on my primary residence with the proceeds, so I will be debt-free. At my age, the potential gains from investing are not all that great, and having a low monthly carrying cost is important, particularly since I am self-employed.

I did the math on this, and putting that money into a IRA or 401(k) or after-tax investment (you can’t invest $400,000 in an IRA in one year) would result in about the same amount of money (perhaps a little less, actually) over 15 years, as opposed to paying off the mortgage, having no debt, not paying all that interest, and then putting the $2500 a month into my SEP and IRA plans instead, for the next 15 years.

Again, at my age, the compound interest earned isn’t as lucrative as when I was 25 years old.

But that freed-up monthly cash-flow will allow me to fully fund my IRA/SEP plans for the next 10 years. And it will make sure I am secure in my home if my job goes away, which happens a LOT to people in their 50’s these days.

ALSO NOTE that the analyst was comparing apples to oranges by saying the rate of return in the market is “better” than the interest saved on a mortgage. A “paid for” home is pretty much a 100% safe investment. It may drop some in value, but not all the way to ZERO like my GM stock did. Even a condo in Vegas is worth something – you can always rent it out. And Real Estate, now that the crash is over, will probably remain pretty flat for the next decade. The worst is over there. I am not sure I can say the same about Stocks.

If you want to compare rate of return, compare the 3.5% after-tax savings on the mortgage interest to what they are offering at the local bank on an FDIC-insured 1-year CD.

Go to your local bank and ask for a 1-year CD (1 year being about how long it takes to sell a house, so the money is effectively tied up for the same period of time) that is FDIC insured for $400,000 with a 3.5% rate of return.

When they stop laughing, they will toss you out of the bank. The best they could do is maybe 0.5 to 1% and guaranteed for only $250,000. Compared to that, paying off your mortgage is a lot better bet.

So that is what I am doing with this lump sum from the sale of my vacation home.

Yes, you can make a lot more in stocks, but you can also lose IT ALL in stocks, and thus end up broke, AND in debt. Bummer on your retirement.

As you get older, you should have more “safe harbor” investments, like bonds, government insured accounts, and…. a paid-for house. At my age (50) this means 50% of my portfolio will be in something very concrete and safe. The remainder I will invest in stocks, leaning more toward safer investments as I approach retirement.

60 and 70 year olds should not be in the market. You can lose it all and have nothing to live on but Social Security.

I live on a retirement island and see first hand how this works out for some folks.. and not others.

I wrote a similar entry in my blog and came to the same conclusion as your financial planner above – the cash-out would knock you into the highest tax bracket, causing you to pay over 1/3 to 1/2 in Federal and State taxes, plus another 10% if you are below 59-1/2. They really have us over a barrel on this one!

The temptation is understandable – people struggling with debt and mortgage payments, but at the same time, seeing that they “have” enough money in their IRA/401(k) to pay off the balance. They have the money, but they don’t.

And then you start to think that perhaps using the IRA Tax Code as an investment guide might not be such a swell idea. You borrow on your house because it is “tax deductible” and at the same time you invest in a 401(k) because it is tax-deferred.

The 401(k) invests in mutual funds, which in tern invest in mortgage-backed securities, which in turn loans money to you in the form of a mortgage. In other words, you are lending money to yourself, paying interest, and paying bankers on both ends of the deal all on the premise that you getting tax deductions.

You cannot deduct your way to wealth, just as you cannot eat your way to slimness.

Paying down debt is a good idea, and long-term, you should look to be debt-free before you retire. But paying off the mortgage with the 401(k) isn’t feasible, due to the tax problems. Note that there are some “self-directed” IRA plans out there that claim you can “lend money to yourself” with them and invest in Real Estate, but these look like audit bait to me.

I cranked the numbers on this, and one thing our investment friend fails to take into account is that if you have no mortgage, and pay that monthly payment into a 401(k) or IRA, it really can grow very quickly into quite a nest egg.

I recently sold my vacation home and am paying off my mortgage on my primary residence with the proceeds, so I will be debt-free. At my age, the potential gains from investing are not all that great, and having a low monthly carrying cost is important, particularly since I am self-employed.

I did the math on this, and putting that money into a IRA or 401(k) or after-tax investment (you can’t invest $400,000 in an IRA in one year) would result in about the same amount of money (perhaps a little less, actually) over 15 years, as opposed to paying off the mortgage, having no debt, not paying all that interest, and then putting the $2500 a month into my SEP and IRA plans instead, for the next 15 years.

Again, at my age, the compound interest earned isn’t as lucrative as when I was 25 years old.

But that freed-up monthly cash-flow will allow me to fully fund my IRA/SEP plans for the next 10 years. And it will make sure I am secure in my home if my job goes away, which happens a LOT to people in their 50’s these days.

ALSO NOTE that the analyst was comparing apples to oranges by saying the rate of return in the market is “better” than the interest saved on a mortgage. A “paid for” home is pretty much a 100% safe investment. It may drop some in value, but not all the way to ZERO like my GM stock did. Even a condo in Vegas is worth something – you can always rent it out. And Real Estate, now that the crash is over, will probably remain pretty flat for the next decade. The worst is over there. I am not sure I can say the same about Stocks.

If you want to compare rate of return, compare the 3.5% after-tax savings on the mortgage interest to what they are offering at the local bank on an FDIC-insured 1-year CD.

Go to your local bank and ask for a 1-year CD (1 year being about how long it takes to sell a house, so the money is effectively tied up for the same period of time) that is FDIC insured for $400,000 with a 3.5% rate of return.

When they stop laughing, they will toss you out of the bank. The best they could do is maybe 0.5 to 1% and guaranteed for only $250,000. Compared to that, paying off your mortgage is a lot better bet.

So that is what I am doing with this lump sum from the sale of my vacation home.

Yes, you can make a lot more in stocks, but you can also lose IT ALL in stocks, and thus end up broke, AND in debt. Bummer on your retirement.

As you get older, you should have more “safe harbor” investments, like bonds, government insured accounts, and…. a paid-for house. At my age (50) this means 50% of my portfolio will be in something very concrete and safe. The remainder I will invest in stocks, leaning more toward safer investments as I approach retirement.

60 and 70 year olds should not be in the market. You can lose it all and have nothing to live on but Social Security.

I live on a retirement island and see first hand how this works out for some folks.. and not others.

I’m 30 years old & agree with the general concept from Certified Financial Planners about leaving your 401K intact, however after losing close to 25% from my 401k in the last year, and with the doomsday mentality in the media, whose to say that anybody can’t stand to lose another 25% to 40% in their retirement accounts due to a failing economy, or having another greedy Bernie Madoff come along and cause another major collapse to our economy.

From the end of 2007 to the end of March 2009, the average 401(k) balance fell 31%, according to Fidelity. Even though accounts have rebounded a little, along with the rest of the market, that’s little help for those who are retired — or were forced to — during the recession. In a system in which one year’s gains builds on the next, the disaster of 2008 will dent retirement savings long after the recession ends!!!

Remember, the biggest factor in whether the 401(k) works as designed has to do with when you retire. If the market rises that year, you’re fine. If you retired last year (2008), you’re toast. And the chances of you becoming a victim of this huge flaw in the 401(k) plan are pretty high. The market fell in “four of the nine years since the beginning of the decade”. That means anyone retiring this decade had a nearly 50% chance of leaving work in a down market. In fact, your chances of retiring into a down market are even greater than that: forced retirements spike in recessions just as the stock market is tanking.

A greedy government combined with greedy bankers and we have the disaster we see today in America!!!

Robertplattbell

You make a lot of good points, and I know people who were retired in 2008, lost 1/3 of their portfolio, panicked and sold it all and put it into bonds, effectively locking in their losses. What 70-year-olds were doing playing the market, I don’t know. By that age, they should be 70% into government-backed bonds, in my opinion.

However, as bad as things got in 2008 – with the media making it out to be worse than it was, many people still had positive equity in their savings and their homes.

For example, have you really “lost money” if you put $50,000 in a 401(k) account that zoomed up to $150,000 in value and now has “plummeted” to $100,000? From where I stand, that is still 100% more than what you put in. And one of my 401(k) accounts did just that. It still works out to a 10% annual rate of return.

Similarly, if you paid $200,000 for a house and it zoomed up to $500,000 in value in 2008 and then dropped back to $300,000 today, have you really “lost money” on the house?

Granted, the people who bought in 2008 are screwed. But a lot of people still do have positive equity in their savings and homes. The idiot-media always fails to mention that salient point.

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